The failure in Washington is disappointing, if not a surprise. However, history tells us it is not necessarily a bad thing for investors. The 16 government shutdowns over the past 37 years, which have ranged from one to 21 days, have not been particularly negative for stock market investors, averaging only a 2% decline for the S&P 500. More importantly, from a longer-term perspective, they preceded above-average returns. The S&P 500 Index has risen 11% on average in the 12 months following the shutdowns, compared with 9% for all periods. Notably, in the last government shutdown 17 years ago in late 1995, the S&P 500 rose 21% in the subsequent 12 months.

As the government shutdown began on the morning of October 1, stocks actually rose after falling modestly in the preceding days. That reaction makes sense, since selling stocks into short-term political uncertainty has been costly for investors in recent years.

Of course, the shutdown is not the only issue facing investors from Washington. We are also approaching a breach of the debt ceiling on October 17, leading to the remote-but-heightened threat of default on some U.S. obligations if lawmakers fail to increase the limit on total U.S. federal government debt. Fear over the threat posed by the debt ceiling seems well contained at this point. For example, the VIX, often called the “fear gauge,” is currently around 16 and not at the 48 level seen in August 2011, when the debt ceiling was last the subject of a battle in Washington and stocks fell 17%. Also, default concerns currently seem minimal with the discount on the one-month T-bill at just six basis points versus 17 basis points at the peak of fear in early August 2011. Perhaps this is because the economic and fiscal backdrop in the United States, and especially Europe, is much improved relative to the 2011 episode.

While it is good news that the markets have been relatively steady, without a negative market reaction there is less pressure on politicians to compromise. Furthermore, the longer the shutdown goes on and the closer we get to the debt ceiling deadline, the more the market is forced to make politicians act. We continue to monitor events closely and believe this is not a time for indiscriminate selling but rather a time to look for opportunities to buy on weakness.

While fourth quarter 2012 earnings results will continue to garner attention, investors may also be looking overseas to gauge market direction, especially with the recent, first meeting of the year for European finance ministers. It is worth remembering that each spring for the past three years, the S&P 500 has started a slide of about 10% during the second quarter, led by events in Europe.

However, this year may be different. In 2012, the European Union finally took two important steps to halt the financial aspect of its ongoing crisis.
One of those steps was the creation of the European Stability Mechanism (ESM), a permanent rescue fund for countries in need of credit and unable to borrow in the market. Another important measure was the authorization of Outright Monetary Transactions (OMT), granting the European Central Bank (ECB) more power to intervene in the bond markets to assist countries in distress.

With these programs able to lend with few limits to banks and willing to buy bonds of any country that will accept the conditions, we do not expect market participants to fear a European financial crisis this spring and drive a 10% decline for U.S. stocks as they have in recent years. But Europe’s crisis is far from over, and market participants may drive stocks lower later this year.

Europe has traded a financial crisis for an economic one. The ECB is able and willing to only fight one crisis. The price Europe has paid to avoid a financial crisis is in the form of recession and unemployment rising above 10% — including France at 10.7%, Italy at 11.1%, Ireland at 14.7%, Portugal at 16.3%, and Spain at 26.2%. The Eurozone is mired in a recession that the ECB has little ability to mitigate. Inflation is still over the 2% target.

This is not just a shift in the crisis facing Europe’s southern countries. It has now started to infect the core. In 2012, the economies of northern Europe, such as Germany, France, and Finland, were less negatively affected with economic growth and lower levels of unemployment more similar to that of the United States than the countries of southern Europe, including Italy, Spain, and Portugal. However, in 2013, the two largest economies of the Eurozone, Germany and France, will face low growth or even stagnation and rising unemployment.

The slowdown in northern Europe can make conditions in southern Europe worse by returning some risk of financial crisis. The economic slowdown in northern Europe may make these countries more reluctant to approve the release of aid packages to the southern countries. This is noteworthy, since if the Italian elections in February 2013 fail to produce a government that achieves political stability and applies economic reforms, the increased market pressure on Italy will likely require financial aid. Germany, the de facto decision maker as a result of making up the lion’s share of any aid package, may already be averse to approve any more unpopular aid packages ahead of the German elections coming this fall. With the elections slowing the decision-making process in Germany, no fundamental changes in policy will likely be made before the elections that may avert the growing economic crisis.
In early 2012, the European fear gauge was the bond yield of southern European countries rising as the financial crisis worsened. But now that a financial crisis has been allayed, the decline in northern European bond yields is a sign of a worsening economic crisis. In a remarkable sign of how the European financial crisis has eased, Portugal’s 10-year bond yield fell from 16% last summer to 6% [Figure 2], and Italian bond yields fell from 7.5% to under 5%. But at the same time, Germany’s 10-year bond yield fell below 1.5% [Figure 3]. This is not a sign of crisis averted, but of a different one brewing. Economists’ estimates for Germany’s gross domestic product (GDP) in 2013 are still coming down. Europe’s 2012 auto sales fell -8.2% from the prior year, the biggest drop in 19 years.
The investment consequences are that the bond yields of southern European countries may once again begin to rise, fall elections highlight the challenges putting pressure on stocks, and recession continues and ensnares more of the core nations of Europe. We may again see a stock market slide related to Europe’s evolving crisis, but it may not be until the summer or fall that it appears this year rather than in the spring. After the powerful rise in European stocks since the financial crisis was averted last summer, investors may be increasingly better off focusing on U.S. and emerging market stocks as the year matures and the European economic crisis deepens.

There’s been consensus for at least a year now that China’s rate of growth will inevitably contract from 2011’s pace of 9.3%. What’s less obvious is how severe the slowdown will be; predicting is notoriously difficult because of the lack of GDP data from the Chinese government. Still, the outlines of what’s being called a “soft landing” and its consequences are becoming clear: China’s growth is expected to decelerate to 7.7% this year.

With much of Europe in recession and recovery in the United States only beginning to show signs of strength, a strong Chinese economy has been critically important for the global economy. In the United States, reduced demand from China is estimated to have lowered American growth by 10 to 20 basis points in the second quarter (a small amount but a fairly large percentage of the 1.3% annualized rate for the quarter), and to be responsible for the loss of 38,000 manufacturing jobs since July.

China is the third-largest buyer of American goods after Canada and Mexico, accounting for 7% of worldwide American exports. Chinese demand is not only a major driver of American manufacturing but also a major factor in the rise of prices for American commodities like coal, paper, and many metals. The cooling of the Chinese economy can be expected to have further short-term effects on U.S. employment growth and profits, and long-term effects on the success of the American recovery.

China, of course, isn’t sitting idly by while growth slows. It has long-term goals of shifting its economy away from heavy reliance on exports and toward domestic-driven growth, and of liberalizing its capital markets to create efficiencies that spur innovation in the economy at large. China’s ability to manage change is hampered, however, by rising labor costs and an aging population, and by the once-a-decade turnover of its leadership that happens at the beginning of November.

Some have an image of China as a centrally managed monolith. It isn’t, though, or it wouldn’t have accomplished the greatest modernization in the history of the planet. It will be interesting to watch how the country and its political and business leadership deal with the first hiccup in that extraordinary growth. Stay tuned.